UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT
GENEVA
TRADE AND DEVELOPMENT
REPORT, 2015
Making the international financial
architecture work for development
Chapter II
Financialization and Its
Macroeconomic Discontents
UNITED NATIONS
New York and Geneva, 2015
Financialization and Its Macroeconomic Discontents
27
Chapter II
Financialization and Its
Macroeconomic Discontents
A. Introduction
The growing influence of financial markets and
institutions, known as “financialization”, affects how
wealth is produced and distributed (UNCTAD, 2011).
Consequently, the increasing integration of developing and transition economies (DTEs) into the global
financial system, and the acceleration of capital flows
into these countries since the turn of the millennium,
have fuelled discussion about the links between openness, financial deepening and economic development.
Increasing financial integration has the potential to
enhance access to external financing for development. However, this chapter argues that there has
been only a weak link between the integration of most
DTEs into global financial markets and their longterm development. This link has experienced further
strains in recent years due to overabundant liquidity
generated by central banks in developed countries.
While several DTEs have exhibited strong growth
and current account surpluses (or lower deficits) over
the past decade, accumulating, in aggregate, considerable external reserve assets, their greater openness
to increasingly large and volatile international capital
flows, especially short-term speculative flows, has
exposed them to the risks of financial boom-and-bust
cycles.1 This chapter details the implications of such
risks from a macroeconomic perspective.
Financial flows to DTEs in the period since the
2008–2009 crisis reflect a previously established
pattern of macroeconomic drivers that started to
emerge in many countries beginning in the 1980s:
a long-term deterioration in the global wage share
and reduced public sector spending in the developed
economies, which have contributed to the dampening of global demand. Global growth has been based
mainly on expanding financial liquidity and the
generation of credit and asset booms. After the crisis,
developed-country policies of quantitative easing,
coupled, after a brief expansionary interlude, with
fiscal austerity, have largely perpetuated this pattern.2 The promise of higher returns on investments
in DTEs, and perceptions that they posed lower risks
than before, made them an attractive alternative
for international investors. However, an increasing
proportion of the resulting financial flows into these
countries has tended to be short-term or of a more
speculative nature, and they are already exhibiting
the type of volatility reminiscent of conditions that
preceded financial crises in a number of DTEs in the
1980s and 1990s.
This chapter first considers financialization in
DTEs at an aggregate level, and highlights the relationship between capital flows and factor income
payments, and the resulting pressures on trade balances. The higher aggregate rates of return on DTEs’
liabilities relative to those earned on DTEs’ assets
are an insufficiently acknowledged and potentially
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Trade and Development Report, 2015
problematic aspect of these relationships. Existing
patterns point to unsustainable trends for the current account, therefore leading to greater financial
fragility. Moreover, in the current context of sluggish recovery from the crisis, which requires strong
contributions to global demand, especially by surplus
countries, the pressure to mitigate the effect of net
factor income losses on the current account is counterproductive for global welfare.
This chapter then discusses the implications
of financialization for domestic macroeconomic
policy. It argues that excessive financial flows alter
prices and influence policy in ways that compromise
the potential for sustainable growth and development. With fully open capital accounts, monetary
authorities become more exposed to the pressures and
expectations of external finance. In particular, large
capital inflows generate pressures for exchange-rate
appreciation, which is exacerbated by a widespread
commitment to maintaining extremely low rates of
inflation as a goal in itself. The reach of fiscal policy
is similarly limited by a compulsion to maintain a
finance-friendly public policy stance, which discourages policy intervention on both the expenditure and
revenue sides. The result is a tendency towards a
deflationary macroeconomic environment, coupled
with structural fragilities in the systems of finance
and productive investment. All of this discourages
both the growth of robust aggregate demand and the
deepening of productive capacity.
The expected repercussions of these fragilities
on domestic aggregate demand are then discussed
by reviewing the history of several financial crises
in terms that link surges in speculative finance with
private sector risk-taking and subsequent public sector losses. Those losses are incurred as governments
eventually and universally assume the risks and costs
generated by private speculation and production failures. A broader, stylized framework then juxtaposes
domestic and external sources of economic growth,
emphasizing how past conditions parallel those that
prevail today.
The chapter concludes with a discussion of a
number of policy responses that developing countries
could consider in the light of these fragilities. Such
responses would aim at better managing financialization and its macroeconomic effects, as well as
strengthening the link between fiscal and monetary
policies and development goals. Strong domestic
financial regulation needs to be at the core of efforts
to harness the benefits of international finance. Instead
of relying on narrowly conceived inflation targets
and high interest rates to manage capital inflows and
the balance of payments, a judicious combination
of capital controls and exchange rate management,
including by influencing the amount and composition of capital inflows, would help maintain access
to productive external finance while also encouraging
domestic investment. Proactive fiscal and industrial
policies are also essential for generating the structures
and circumstances that support domestic productivity
growth and the expansion of aggregate demand. Given
the extent of financialization and the large size of
global capital flows, however, macroeconomic management at the national level must be supplemented
by global measures that discourage the proliferation
of speculative financial flows. Further support can
be provided at the regional level by means of more
substantial mechanisms for credit support and shared
reserve funds. Policy coordination should also extend
to domestic macroeconomic management. And such
measures have a greater chance of success if they are
implemented regionally and, ultimately, globally.
Financialization and Its Macroeconomic Discontents
29
B. The challenges of global liquidity expansion
1. Liquidity expansions before and
after the crisis
Inadequate global demand is a primary problem
resulting from the Great Recession that has yet to
be resolved. In part, this reflects an ongoing failure
to re-link finance to sustainable income generation
and spending. In the run-up to the financial crisis of
2008–2009, effective demand in major economies
was not supported by a sustained growth of wage
income, which is the main factor driving household
demand, nor, in most cases, was it supported by rising
public sector spending. From the 1990s, fiscal stances
were either moderating or being subject to downward
adjustments in most of the major economies. The
exception was the United States between 2001 and
2004, where extraordinary fiscal injection helped lift
the economy after the dot-com crash. In the absence
of these two main drivers, GDP growth was based on
liquidity creation, initially by monetary authorities
and then by private financial institutions (see chapter
III). In some of the major economies, this succeeded
in boosting demand through asset appreciations
and borrowing, leading to consumption booms and
private investment bubbles. The counterpart driver
in other economies was net export demand. This
hazardous configuration of finance and demand was
very different from the process of credit creation
that sustains production and employment generation.
Likewise, in the recovery from the 2008–2009
crisis, the failure to reverse the long-term deterioration of the wage share, which began in many
countries in the 1980s, was compounded by a general
shift to fiscal austerity by most developed economies
after the brief expansionary episode of 2009–2010.
This left recovery almost exclusively dependent on
renewed liquidity expansion. However, there are
some important differences between the pre- and
post-crisis periods that help explain the recent configuration of growth and financial positions across
the global economy.
The first and most obvious difference is the
post-crisis rise of public sector deficits in developed economies, an inevitable analogue of the
unprecedented balance sheet adjustments of banks,
businesses and households. The second difference is
that this time liquidity creation has been engineered
by central banks, unlike during the pre-crisis period
when the main trigger for liquidity creation was
excessive leveraging by the private (and shadow)
banking sector.3 A third difference, a consequence
of the first two, is that liquidity expansion has been
channelled through financial sectors as portfolio
assets, including in developing countries, and is
therefore mostly detached from the real economy.4
The latter became apparent in the rise of crossasset correlations among global equities, commodity
markets and currencies in the early 2000s (TDR 2011,
UNCTAD 2012a). Portfolio allocations between
equity and currency markets reflected mostly riskon/risk-off perceptions, while perceived benefits
from diversification drove commodity investment
and reduced the link between asset prices and the
performance of the underlying real assets, especially
between mid-2008 and mid-2013. This contributed
to a noticeable rise in volatility across all markets.
Since 2013, fundamentals have been more significant
in explaining price movements for most primary commodities (see chapter I). In this context, the changing
degrees of importance of drivers of price formation
in real, financial and foreign-exchange markets have
considerably undermined the ability of policies to
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Trade and Development Report, 2015
influence real economic performance or mitigate
external shocks.
As far as DTEs are concerned, their performance, both in the pre- and immediate post-crisis
periods, has generally been characterized by a combination of supportive domestic demand and export
buoyancy. As a group, they have also enjoyed greater
domestic financial stability than developed countries,
despite increased liberalization of financial flows and
opening up that has allowed a greater presence of
foreign banks and investors in their domestic markets.
However, global financialization in the absence of
sufficient regulation of domestic financial markets
has left DTEs more exposed to the consequences of
boom-and-bust cycles of capital inflows, as noted
in earlier TDRs and other studies (Akyüz, 2008 and
2011). Exposure to any shock emanating from external financial cycles could quickly erode the strength
of domestic demand in several DTEs, with potential
repercussions for the stability of the global economy.
In China, where monetary policy sterilization
and reserve accumulation have largely moderated the
impact of capital inflows, overindebtedness in sectors
linked to the construction boom is becoming a growing concern for policymakers (Chandrasekhar and
Ghosh, 2015; Magnus, 2014).5 Although a slowdown
of investment can be expected, if this coincides with
a sharp decline in housing construction and infrastructure building, it could contribute to a reversal
of the large short-term and equity capital inflows
(as detailed below). In other DTEs, socially more
inclusive policies have played a relatively effective
role in supporting domestic demand by implementing
countercyclical fiscal measures, advancing strategic
plans for export diversification away from primary
commodities (with limited success), socializing
gains from commodity extraction, and moderating
the effects of excessive capital inflows via reserve
accumulation or different forms of capital controls.
Nevertheless, there remains a strong possibility that
the scope and impact of such policy measures could
be insufficient to counter the considerable size and
consequent influence of global financial markets.
Indeed, the “taper tantrum” of 2013, which generated
substantial shocks to performance and deflationary
policy reactions in several developing countries,
could prove a (mild) harbinger of possible capital
reversals to come (Neely, 2014; UNCTAD, 2014).
The landscape may be more challenging in DTEs that
have not implemented any countervailing policies to
manage financialization.
2. The rise and aggregate risks of
capital inflows to DTEs
Comprehensive records of external flows and
stocks for a large number of DTEs confirm that their
exposure to external sources of financing has con­tinued
to rise (Chandrasekhar, 2007; Gallagher, 2015).6 Gross
annual debt flows (net flows plus debt repayments)
to DTEs reached nearly $1 trillion in 2013. This is
about five times more than in 2002, the last significant trough after the sequence of financial crises in
the late 1990s and the dot-com crash in 2001, when
gross debt flows to DTEs amounted to $204 billion.
It should be noted that a rising share of gross annual
debt flows is on account of debt repayments, which
grew proportionally to the volume of accumulated
liabilities over time. However, there was also a huge
rise in net debt flows (i.e. gross inward flows minus
repayments), from $3.5 billion in 2002 to $535 billion in 2013. Net equity inflows into DTEs, which,
according to the World Bank’s International Debt
Statistics 2015, comprise portfolio equity as well as
direct investment, rose more than fourfold during that
period, from $152 billion to $637 billion (chart 2.1).
These increases of external flows to DTEs
do not seem so staggering considering that these
economies experienced a period of nearly uninterrupted rapid economic growth after 2003, despite
being affected to varying degrees by the global
financial crisis. Comparisons of the same flow variables noted above as a per cent of aggregate gross
national income (GNI) are captured in chart 2.1. By
this measure, there was a considerable rise of gross
and net debt flows from 2002 to 2007, resuming again
in 2010. Particularly for gross flows, the pattern is
similar to the boom cycle of the 1990s, though not
as dramatic as that of the 1970s which led to the debt
crises of the early 1980s. Net equity inflows as a per
cent of GNI experienced fluctuations as well, but
from a consistently higher level from the mid-1990s
onwards. As a proportion of GNI, both sources of
external inflows to DTEs together (debt and equity)
increased from 2.8 per cent in 2002 to 5 per cent in
2013, after having reached two historical records of
6.6 per cent in 2007 and 6.2 per cent in 2010.
Financialization and Its Macroeconomic Discontents
31
Chart 2.1
Foreign capital inflows into developing and transition economies
by components, 1970–2013
(Billions of dollars and percentage of GNI)
10
1 600
9
1 400
8
Percentage of GNI
1 800
$ billion
1 200
1 000
800
600
7
6
5
4
3
400
2
200
1
0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2013
0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2013
Total capital inflows
Inflows used to repay principal on outstanding debt
Net debt inflows
Net equity inflows
Source: UNCTAD secretariat calculations, based on World Bank, International Debt Statistics (IDS) database.
These aggregate patterns are not unique to the
larger DTEs, which have relatively more developed
financial and capital markets. Lower-income DTEs7
may have absorbed a considerably smaller volume
of capital flows, but their patterns are similar to those
of the group as a whole, showing a clear rise from
2002 to 2013, with peaks in 2007 and 2010. As a
proportion of GNI, both sources of external flows
to this subgroup of DTEs together (debt and equity)
increased from 2.5 per cent in 2002 to 5.1 per cent
in 2013, after having reached a historical record of
7.7 per cent in 2007.
Relative to earlier periods, from 2003 onwards
most DTEs experienced strong growth and current
account surpluses or lower deficits, suggesting that
financing needs for development may not have been
the main driver of the boom in capital inflows.8
Rather, “push” factors like monetary conditions and
risk perceptions of developed-country investors, in
tandem with stock market appreciations in DTEs,
may have been the dominant drivers (see TDR 2013,
chap. III for a detailed econometric exercise). Not
unrelated is the fact that DTEs as a whole, particularly
the larger economies of this group, accumulated considerable amounts of external reserve assets during
this period (chart 2.2).9 Under these circumstances,
reserve accumulation primarily reflects an excess of
inflows over the amounts that would normally be
consistent with domestic spending and investment
patterns. By 2013, over 40 per cent of the reserves
held by DTEs were “borrowed”, in the sense of not
deriving from a current account surplus, but rather
set aside from capital inflows (Akyüz, 2014: 11).
While policy makers often see reserve accumulation as a precautionary measure, there are limits to
this strategy. Given the levels of inflows and reserve
accumulation, an important question is whether these
patterns are consistent with financial stability and
sustained global demand.
When considering the balance of payments,
the focus is often on trade deficits and surpluses,
on the assumption that net factor incomes10 will
simply reflect a neutral pattern of capital flows. But
the determination and implications of the factor
income balance involve a few complexities. First,
factor incomes depend on the volume of assets and
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Trade and Development Report, 2015
Chart 2.2
Foreign reserve stocks in developing
and transition economies, 1970–2013
(Percentage of GNI)
30
25
20
15
10
5
0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2013
Total for developing and transition economies
Developing and transition economies
excluding major economiesa
Source: UNCTAD secretariat calculations, based on World Bank,
IDS database.
a The major economies excluded are Argentina, Brazil,
China, India, Mexico, South Africa and Turkey. Also
excluded are Algeria, Egypt, Libya, Morocco and Tunisia.
The Russian Federation is not in the IDS sample.
liabilities, as well as on their rates of return. In turn,
assets and liabilities are accumulated from the outward and inward flows respectively. Second, a current
account surplus, by definition, equals a net outflow
of funds on the “capital and financial account”
(hereafter referred to as the “capital account”).11
Conversely, a current account deficit will equal net
inflows of capital. But this does not mean that an
economy will receive precisely the amount of gross
inflows that match the current account deficit, or have
gross outflows that exactly equal the current account
surplus. Rather, inflows and outflows are partly the
autonomous result of investors’ perceptions, leading
to mismatches between finance and the real economy.
As noted above, capital inflows in excess of those
required to finance a current account deficit end
up as residents’ private capital outflows or reserve
accumulation by a central bank. Likewise, surplus
countries which, in addition to their earned foreign
exchange from trade, receive large amounts of private
inflows end up accumulating “borrowed” reserves.
Taking into consideration that rates of return
paid to foreign investors are usually greater than
those obtained by private residents or central banks
of developing countries, the end result is that the balance of factor incomes often may have a tendency
to worsen the current account.12 For example, rising
net (positive) investment positions of surplus DTEs
could eventually coexist with declining net factor
incomes. These disadvantages are magnified for
DTEs with prolonged current account deficits, where
the accumulated reserves are mostly “borrowed”.
Thus, with worsening net factor income imbalances
and trade deficits, these DTEs will face growing net
liability positions. If deficit DTEs do not succeed in
improving their trade performance, they must depend
on capital inflows to fulfil their external obligations.
By implication, these are extremely fragile “Ponzi
finance” schemes, where current liabilities can only
be met by greater borrowing, and any small change
in circumstances or sentiment, internal or external,
can destabilize both the financial system and macroeconomic conditions (Minsky, 2008).
DTEs generally aim at improving trade performance for a variety of reasons related to growth, and
technical progress, among others. But the prospects
of ever larger net factor payment outflows due to
the accumulation of inherited liabilities and unequal
rates of return may intensify the search for economic
strategies to increase net exports, including by reducing imports.13
In sum, the empirical evidence reveals that
financialization is associated with a continuing rise
of global capital flows to DTEs.14 Furthermore, DTEs
face uneven rates of return on their assets relative
to their liabilities. From a global perspective, these
patterns combined may be problematic in ways that
have not been sufficiently acknowledged. First,
economies may find themselves in a situation where
a deterioration in their factor incomes account leads
to increasing liabilities on Ponzi-finance-type terms.
Second, in the current circumstances of sluggish
recovery from the crisis, when efforts need to be
made to boost global demand, especially by surplus
countries, the aim of achieving trade surpluses in
order to mitigate net factor income losses creates a
contractionary bias.
Financialization and Its Macroeconomic Discontents
3. Greater financial integration and
increasingly unstable capital flows
Mainstream views on financial integration stress
that it will be beneficial for both investors and recipient countries, provided that it takes place within a
“sound” macroeconomic framework. Recommended
policies for DTEs include reducing government intervention (creating a correspondingly bigger role for
financial institutions such as private banks and pension funds) and increasing competition and structural
reforms in product and labour markets (Caruana,
2011; Milken Institute, 2014a; OECD, 2011).
By contrast, the analysis here adopts a broader
and more critical approach to financialization by
emphasizing how both push and pull factors have
influenced the re-emergence of risks for DTEs since
the financial crisis. These greater risks stem from
external as well as domestic conditions. External conditions include excessive global liquidity, driven most
recently by quantitative easing in developed countries
that was insufficiently matched by an expansion of
demand because of fiscal austerity.15 Within DTEs,
risks have tended to stem from macro-financial
policies that disregard the importance of domestic
financial regulation and underestimate the potentially
deleterious effects of speculative bubbles. Therefore
this section stresses the composition of portfolio
flows as a guide to an assessment of potential risks.16
During the course of the past 10 years, the
weight of private, non-guaranteed, short-term speculative flows has increased significantly in the external
portfolios of many of the larger DTEs (chart 2.3) as
well as for all the DTEs taken together, excluding the
countries illustrated individually.17 Chart 2.3 traces
patterns of more speculative capital inflows relative
to total inflows as a share of GNI; the difference
includes mostly long-term or publicly-guaranteed
loans to public sector institutions and foreign direct
investment (FDI). Admittedly, there are significant
differences in terms of initial conditions, behaviour
and other factors among such a varied group of countries. Chandrasekhar (2015), for example, stresses the
influence of previous and recent financial crises on
the direction of countries’ policy responses. A case
in point is Indonesia, where re-regulation and capital
controls in the aftermath of the 1997–1998 Asian
financial crisis help explain why capital inflows did
33
not recover until well into the mid-2000s. Another
case is that of Argentina, where the amount of net
capital flows remained moderate after the 2001–2002
crisis.18 Other authors, such as Gallagher (2015),
propose a mapping of cross-border financial regulations in the wake of the 2008–2009 financial crisis,
highlighting the cases of Brazil, Peru, the Republic of
Korea and Thailand, which implemented second- and
third-generation measures, price-based controls and
foreign-exchange regulations respectively.
Observations on diversity notwithstanding,
the set of countries presented in chart 2.3 shows a
considerably large proportion of typically unstable
or unreliable flows in the total, strongly driving
upswings and downswings, which, in some cases,
have been dramatic. Within periods of one or two
years, in almost all of these economies the size of net
inflows has varied by more than 5 per cent of GNI in
either direction, apparently driven by fluctuations in
the combination of private, non-publicly-guaranteed
debt, short-term debt and portfolio equity (i.e. unstable) flows. In some countries such as South Africa and
Turkey (as well as Ukraine until the crisis of 2013),
such unstable flows represent almost the totality of
inflows, which, combined, can add up to fairly significant proportions of more than 6 per cent of GNI.
These flows are even larger for other countries such
as India, Malaysia and Thailand. Among the selected
sample, only China, Indonesia and Mexico reflect
situations where most of the inflows may not be of a
short-term or unstable nature. This can be explained,
at least partly, by the greater role of regulation in the
two former countries.
These patterns represent increasing vulnerabilities for DTEs, not only because of their size relative
to GNI, but in particular because of the fact that some
markets, such as stock markets, foreign-exchange
markets and in some cases even real estate markets,
operate in spheres relatively beyond the reach of public
policy. These markets are typically unstable and highly
correlated with one another, which exacerbates the
potential for destabilizing co-movements. And while
it may be difficult to measure the size of foreignexchange markets from the perspective of a single
economy, domestic capitalization measures of stock
markets are telling: for this sample of DTEs presented
in chart 2.3, domestic capitalization is generally considerable, in some cases greater than 100 per cent of
GDP (Akyüz, 2014; Milken Institute, 2014b).
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Trade and Development Report, 2015
Chart 2.3
Composition of capital flows, selected developing
and transition economies, 2002–2013
(Percentage of GNI)
10
Argentina
Brazil
10
8
10
8
8
4
6
6
2
4
4
2
2
6
0
-2
-4
-6
-8
-10
10
2002 2004 2006 2008 2010 2012 2013
India
6
4
2
0
-2
14
0
-2
-4
2002 2004 2006 2008 2010 2012 2013
Indonesia
10
8
-4
0
-2
2002 2004 2006 2008 2010 2012 2013
Mexico
25
6
20
4
15
2
10
0
5
-2
0
-4
-5
-6
2002 2004 2006 2008 2010 2012 2013
South Africa
14
4
6
4
2
4
-4
14
0
-2
-2
2002 2004 2006 2008 2010 2012 2013
Turkey
-4
-2
2002 2004 2006 2008 2010 2012 2013
Ukraine
30
12
25
10
20
8
2
0
0
0
-2
-5
-4
-10
2002 2004 2006 2008 2010 2012 2013
Other DTEs
4
5
2
10
2002 2004 2006 2008 2010 2012 2013
6
10
4
-4
8
15
6
Thailand
2
0
0
2002 2004 2006 2008 2010 2012 2013
8
6
2
Malaysia
10
6
8
-10
2002 2004 2006 2008 2010 2012 2013
12
8
10
30
8
10
12
-4
China
-2
2002 2004 2006 2008 2010 2012 2013
Short-term net debt inflows
Net portfolio equity inflows
-4
2002 2004 2006 2008 2010 2012 2013
Long-term, private non-guaranteed net debt inflows
Total net inflows
Source: UNCTAD secretariat calculations, based on World Bank, IDS database.
Financialization and Its Macroeconomic Discontents
In many countries and in the DTE subgroup,
the gap between the total and the combination of
unstable flows includes FDI and non-portfolio equity
inflows (chart 2.3). FDI in productive activities,
especially in industrial sectors that underpin development, can positively contribute to development.19
This is particularly the case when FDI in the form of
greenfield investments is appropriately absorbed at
the national level. However, FDI data in aggregate
should be interpreted with caution. For example, the
classification of FDI typically refers to the size of the
ownership stake (10 per cent or more, according to
the IMF), and not to the liquidity of the investment.
Indeed, financial innovation and the deepening of
financial markets can make large ownership stakes
more apparent without significant changes in the
liquidity of investments. Another example is the fact
that real estate, a highly liquid and volatile sector,
attracted the most greenfield FDI in 2014, and of the
top 20 recipients, all but 4 were developing countries.20
Furthermore, the potential magnitude of factor
income payments related to FDI needs to be considered. In 2014, the value of global FDI income
exceeded that of all FDI inflows.21 Economies that
are major recipients of FDI may experience the
sorts of balance-of-payments instabilities discussed
above, since maintaining a sustainable growth path
requires generating sufficient foreign exchange to
cover external payments, particularly in the context
of large profit outflows (TDR 1999). If FDI inflows
were to slow down, the problem of covering even a
modest repatriation of profits could quickly become
35
acute, especially when a large proportion of FDI inflows consists of reinvested earnings and may
behave more like portfolio flows than long-term flows
(Kregel, 2014b).22
This picture of unstable capital flows echoes the
experience of many developing countries in the late
1980s and the 1990s (as discussed below). Although
the combined share of private, short-term and equity
capital flows as a percentage of GNI is now larger
than it was in those two decades, at the time, many
developing countries started to rely on such forms of
financing, since debt markets remained virtually dry
after the debt crisis that erupted in 1982. Singh and
Weisse (1998), in a critical analysis of the interactions
between speculative capital flows and stock markets
in developing countries, concluded that the resultant volatility, likelihood of macro-financial shocks,
misallocation of resources, and severe disruptions
to long-term development goals called into question
the argument that developing countries should turn
to stock markets as a way of mobilizing resources
for sustainable development.
Combining these points on volatility arising from
the structure of global capital flows with the aggregate fragilities stemming from countries’ balance of
payments, this section argues that the expansion of
unstable, short-term and speculative flows presents a
challenge for using such external finance in ways that
could enhance development. The next section takes
up the question of the challenges and opportunities
for domestic macroeconomic management.
C. The macroeconomic costs of financialization
1. Effects of unfettered financial
integration on prices and policy
In addition to the macro-financial risks identified above, unstable financial flows to DTEs have
effects on key prices, such as exchange rates, and at
the same time they constrain monetary and fiscal policies. So-called “balance-of-payments-constrained”
growth frameworks provide a basis for understanding
the myriad connections and lines of causality between
external flows and economic growth. They are based
on the insight that to achieve sustained growth it is
necessary to balance imports and net factor income
payments with exports in a sustainable manner.23 For
instance, the size of the current account deficit or
external debt relative to domestic income can limit
pathways to stable growth. Policymakers may change
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Trade and Development Report, 2015
course by either reducing domestic expenditure, and
thus imports, or supporting investments that trigger
faster output growth, such as by increasing exports
(Moreno-Brid, 1998). Alternatively, according to
this approach, conditions in international financial
markets can determine the extent of foreign financing available, which in turn affects imports and fixed
investments, eventually determining the trade balance
and the growth trajectory (Barbosa-Filho, 2001).
These relationships are perhaps most immediately apparent in terms of how financial flows, in
combination with monetary policy reactions, affect
prices. Influencing the real exchange rate to maintain
competitiveness and encourage the production of
tradables represents a challenge for policymakers in
DTEs. Excessive nominal exchange rate depreciation
will tend to exacerbate domestic price inflation due
to the higher cost of imported capital and consumption goods. Conversely, excessive nominal exchange
rate appreciation, when not sufficiently compensated
by lower domestic inflation, may create a tendency
towards real exchange rate appreciation that has a
prolonged effect on the current account. Navigating
within these constraints is difficult for central bank
policy in developing countries.
Interventions in the foreign-exchange market to
avoid an appreciation of the domestic currency lead
to monetary expansion, which central banks usually
try to sterilize by selling government securities in
money markets. However, these operations may not
necessarily result in interest rates that are stable and
consistent with real demand; generally, the interest
rate tends to overshoot and is followed by a drastic
fall. A higher interest rate exerts further upward pressure on the exchange rate as foreign investors respond
by engaging in interest rate arbitrage. Even assuming
that exchange-rate management and reserve accumulation may be helpful in the context of capital inflows,
often, this policy is not symmetrical. Authorities
usually have greater difficulty coping with capital
reversals. Using a large amount of reserves to meet
demand for foreign currency can risk eventually
emptying the coffers.24 Usually, money market operations aimed at raising the interest rate are activated.
Independently of whether the central bank is
engaged in explicit exchange-rate management, if the
behaviour of the central bank is driven by a narrow
inflation target rule, there will be a tendency towards
nominal appreciation (for further explanation, see
Barbosa-Filho, 2012). Inflation-targeting frameworks
typically tend to conform to narrow monetarist ideas
about the existence of an exogenous supply of money
and its impact on inflation. Thus, following surges of
capital inflows, monetary authorities may consider it
critical to avert an inflationary spiral resulting from
the increase in money supply. But capital outflows
leading to exchange-rate depreciations can also trigger inflationary pressures via the pass-through effects
of import prices. In the context of inflation-targeting,
independently of the source of inflationary pressures,
the critical instrument to tame the inflation rate is the
interest rate, which often brings with it pressure for
nominal appreciation. If this effect is stronger than
the presumed effect of reducing the inflation rate,
a real-exchange-rate appreciation follows, with the
potential of a currency crisis if the current account
deteriorates significantly. As a matter of fact, high
interest rates have perverse effects on price formation, as producers tend to pass on the higher cost
of borrowing by raising prices (Lavoie, 2001). The
destabilizing effect of speculative capital movements
on nominal exchange rates, combined with inflation
targeting regimes that aim at high interest rates, may
not only create balance-of-payments problems in the
short run, resulting from an overshooting and successive corrections of interest rates; it may, in the long
run, also translate into slower growth, because real
exchange rates tend to remain appreciated in order
to avert financial shocks, effectively damaging the
current account (Frenkel and Rapetti, 2009).
Chart 2.4 illustrates some of the mentioned
interactions between capital flows, exchange rates
and short-term policy rates for the same countries
shown in chart 2.3. In some cases, the suggested
influences of external capital on the macroeconomic
environment seem unambiguous. Increases in capital inflows in excess of what is needed to finance
real demand tend to exert upward pressure on the
exchange rate. This influence may be magnified
during commodity price booms for net commodity
exporters. Brazil, Malaysia, Ukraine and to some
extent India appear to be representative of these patterns, while China is an exception, as the authorities
have managed a steady appreciation of the exchange
rate. For the entire group of DTEs, the relationship
holds quite well despite the high level of aggregation.
In other cases (e.g. South Africa and Turkey), the
correlation applies only for selective years, while in
Thailand the variations in the exchange rate seem to
be influenced by the pace of capital inflows over the
Financialization and Its Macroeconomic Discontents
37
Chart 2.4
Net capital inflows, nominal exchange rates and nominal interest
rates in selected developing and transition economies, 2002–2013
40
Argentina
1.5
30
1.0
20
40
Brazil
China
1.5
15
1.0
10
1.0
0.5
5
0.5
0.0
2002 2004 2006 2008 2010 2012 2013
0
0.0
2002 2004 2006 2008 2010 2012 2013
30
1.5
20
10
0.5
0
-10
15
0.0
2002 2004 2006 2008 2010 2012 2013
India
10
10
0
1.5
20
1.0
10
Indonesia
1.5
1.0
20
Malaysia
15
1.5
1.0
10
5
0.5
0
0.5
0
0.0
2002 2004 2006 2008 2010 2012 2013
-10
0.0
2002 2004 2006 2008 2010 2012 2013
15
Mexico
10
1.5
15
1.0
10
South Africa
1.5
1.0
0.5
5
0
15
0.0
2002 2004 2006 2008 2010 2012 2013
Thailand
10
1.5
1.0
5
5
0.5
5
0.5
0
0.0
2002 2004 2006 2008 2010 2012 2013
0
0.0
2002 2004 2006 2008 2010 2012 2013
40
Turkey
1.5
30
20
1.0
40
Ukraine
0.5
0
-5
0.0
2002 2004 2006 2008 2010 2012 2013
Other DTEs
1.5
15
1.0
10
1.0
0.5
5
0.5
0.0
2002 2004 2006 2008 2010 2012 2013
0
0.0
2002 2004 2006 2008 2010 2012 2013
30
1.5
20
10
0.5
0
-10
0.0
2002 2004 2006 2008 2010 2012 2013
10
0
Total net inflows (percentages of GNI)
Short-term interest rate (per cent)
Exchange rate ($ per local currency, 2000 = 1) (right scale)
Source: UNCTAD secretariat calculations, based on World Bank, IDS database; IMF, World Economic Outlook, April 2015; and IMF,
International Financial Statistics database.
38
Trade and Development Report, 2015
medium term, with central bank intervention acting
over the short term. Argentina shows a steady currency
depreciation in nominal terms, resulting not from capital movements (which remained subdued), but rather
reflecting its inflation rate and proactive exchange-rate
management. In these more ambiguous cases, it seems
that other drivers, including some degree of proactive
policy management, may be the cause of exchange rate
fluctuations. Indonesia, as noted earlier, has for several
years maintained varying regimes of exchange-rate
management, while the resumption of capital inflows
seems to have responded to the commodity boom that
started in 2003–2004.
Typically, the correlations between capital flows
and exchange-rate cycles are more pronounced in
the short term. Indeed, drastic capital flow reversals
occurred in mid-2013 in many of the economies
discussed here following the announcement by the
United States Federal Reserve that it would reduce
the pace of quantitative easing. Sharp depreciations
followed, and in some economies it took specific
monetary policy responses to halt the turnaround.
Fears that instabilities of this kind, and perhaps of a
greater magnitude, will emerge following a tightening
of United States monetary policy are justifiable in view
of such experiences. Some short-term monetary policy
responses to changes in capital flows are discernible in
the annual flows shown in chart 2.4, where decelerations in the pace of capital inflows are followed by
interest rate increases – a pattern that is often quickly
reversed. In these cases, interest rate fluctuations can
be sharp from one year to the next. This volatility
may have damaging effects on financial stability and
on the environment for productive long-term investment. What is more, because high interest rates are
often not sufficiently effective, or may even hamper
efforts to control inflation, a resulting tendency
towards appreciation of the real exchange rate will
have lasting effects on the current account.
To sum up, it appears that, for the most part, the
economies shown in chart 2.4, as well as many others,
have been adversely affected by the globalization of
finance as a result of perverse effects on exchange
rates, and volatile and often high interest rates. In
some countries, some degree of capital controls may
have helped mitigate these effects (Gallagher 2015;
Ostry et al. 2010).
Exchange rates, the balance of payments and
monetary policy are the most frequently discussed
aspects of the macroeconomic consequences of
financial flows. However, financialization also may
exert general deflationary pressures on national
economies, partly as a result of the constraints that
open capital accounts impose on fiscal policy (Patnaik
and Rawal, 2005; Patnaik 2006).25 As noted above, in
an environment characterized by free and typically
unstable financial flows, policymakers cede control
over the domestic interest rate, with the result that the
rate that prevails is generally higher than what would
be appropriate to support domestic capital formation,
dampening economic activity and lowering GDP. In
addition, financialization and open capital accounts
exert macroeconomic pressures that tend to restrict
fiscal policy. Interventionist policies and expansionary fiscal stances, no matter how important they are
for development, may be a concern for international
finance. Whether these sentiments stem from a fear
of unsustainable debt accumulation or inflation, or
a desire to expand the scope for private investors
by limiting the reach of the public sector, or simply
from resistance to a proactive role for the public
sector, the result tends to be the same: policymakers
become apprehensive that government spending may
drive finance away (Krugman, 2000; Patnaik, 2006).
Recent debates about fiscal austerity and growth
reflect both this concern and the prevalence of the
idea that public deficits and debt are unequivocally
bad for growth, even when the empirical evidence
shows otherwise (Herndon et al., 2013).26 On the
revenue side, tax receipts may decline for two related
reasons: first, due to lower levels of economic activity
associated with weaker public stances; and second
due to ongoing pressures to offer international investors favourable tax rates lest they move elsewhere.
The upshot is less government activity, which directly
reduces national income as a result of limited government spending, but also indirectly lowers productive
capacity by restricting the types of public investments
in physical and human capital that support private
investment and productivity growth.
Furthermore, openness of the capital account,
by strongly altering relative prices and demand patterns, may have longer term effects as well, including
by creating deindustrialization pressures in DTEs.
Given this risk, it is important to consider the interaction between, and sequencing of, liberalization of
the capital and current accounts. This has been, in
particular, the experience in parts of Latin America
and sub-Saharan Africa (dating back to the late 1970s
in some countries), where capital account deregulation, which initially led to massive capital inflows
and currency appreciations, took place at the same
Financialization and Its Macroeconomic Discontents
time as increased openness to trade. The lower cost
and greater variety of industrial imports constituted
a gain for consumers and a source of imported inputs
into production; but they also depressed the relative
prices of tradable goods and services (both imported
and exported), squeezing domestic profit margins
and wages, and lowering domestic investment and
employment.
Recent empirical evidence shows how, in econo­
mies with less developed manufacturing industries,
these conditions can hollow out local capacities
(TDR 2003; Rodrik, 2015).27 This has meant lost
opportunities for growth and for an expansion of
higher quality employment, since industrial growth
is essential for both. Indeed, in such cases, there has
been an increase in often informal, lower productivity
service sector jobs.
Thus, financialization and open capital accounts,
and the higher interest rates they often require to
maintain stability, compromise domestic investment and the ability of governments to support it,
independently of whether any inflows or outflows
have taken place (Patnaik and Rawal, 2005; Kregel,
2014c). When inflows or outflows do occur, they
can have deleterious effects on industrialization and
development in various ways. As discussed above,
capital inflows exert pressures for real exchange rate
appreciation and elevate the primacy of short-term
returns in speculative markets over long-term projects that raise productive capacity (Patnaik, 2003).
This makes it more difficult to conduct the type of
structurally transformative investments required for
development. On the other hand, sudden stops or
capital flow reversals can turn deflationary tendencies
into contractionary crises, resulting in substantial real
economic and human costs and relegating fiscal policy
to servicing debt rather than supporting development.
The next section uses the recent history of financial
crises in DTEs as a guide to determining the consequences of such overexposure to speculative finance.
2. Learning from the past: Public sector
finances and economic development
after financial crises
As discussed above, financial liberalization
and deregulation provide an opening for a surge of
capital flows as well as domestic lending, adding to
the likelihood of bubbles in stock markets and real
39
estate markets. Such large inflows are often magnified by the way fiscal and monetary policies adapt to
investors’ expectations. The consequent build-up in
financial fragility, driven by largely private speculation
and risk-taking, is often swiftly unwound by a crisis,
with substantial negative real effects and a sharp rise
in public debt. Table 2.1 lists countries and the dates
of their currency, sovereign debt or banking crises,
grouped by the four waves of financial crises identified:
various debt crises in the 1980s, the Mexican crisis in
1994–1995 and its so-called tequila effects, the Asian
financial crisis in 1997–1998, and its ripple effects
on countries outside the Asian region.28 It is not a
complete list of all of the financial crises that occurred
during these periods, but rather a representative
sample dictated by data availability and core themes.
Almost all of these crisis episodes listed (31 out
of 33) were preceded by a “capital flow bonanza”,
defined as an unusually large negative surge in the
current account balance.29 Similarly, domestic credit
booms preceded crisis nearly 75 per cent of the time
(24 out of the 33 episodes listed). In the table,
minimum real per capita GDP growth refers to the
minimum growth rate within four years of the start
of the crisis (including the crisis year, recorded as
the earliest year that any of the three types of crises
began, and is referred to as time T). Its intent is to
make inferences, however rough, about the output
losses resulting from these crises. The last two
columns indicate the costs of the financial crises in
terms of the growing public debt, both to domestic
and external creditors. Comparing public debt as
a share of GDP the year before the financial crisis
begins (T-1) relative to two years after (T+2) for the
entire group of crises listed, the median (average)
increase in total gross central government debt is
85.9 (124.3) per cent, while the median (average)
increase in external government debt is 42 (60.5) per
cent. Interestingly, although fiscal mismanagement is
a frequent refrain in mainstream accounts of financial crises, it is typically the public fielding of the
private bust, and all the costs associated with it (e.g.
nationalizing private debt, recapitalizing banks, and
the impact of currency devaluation on the value of
foreign currency liabilities), that run up public debt.
(a) Lessons of the 1980s
The Latin American debt crises of the 1980s
caught many investors and analysts by surprise.30
The world had not witnessed a major financial
40
Trade and Development Report, 2015
Table 2.1
Periods of financial crises, capital flows and public debt
Country
Debt crises of the 1980s
Argentina
Chile
Mexico
Uruguay
Colombia
Ecuador
Paraguay
Turkey
Venezuela (Bolivarian Rep. of)
Brazil
Peru
Philippines
Argentina
Peru
Venezuela (Bolivarian Rep. of)
Brazil
Group median
Tequila crisis
Mexico
Argentina
Group median
Asian financial crisis
Indonesia
Republic of Korea
Malaysia
Philippines
Thailand
Group median
Ripple effects from
the Asian financial crisis
Colombia
Ecuador
Russian Federation
Ukraine
Brazil
Turkey
Argentina
Paraguay
Uruguay
Venezuela (Bolivarian Rep. of)
Group median
Minimum
annual real
Sovereign Banking
per capita
Currency debt crisis
crisis
Capital Domestic GDP growth
crisis
(default (starting
flow
credit
(year)
year)
year)
bonanza boom
1981
1982
1982
1983
1985
1982
1984
1982
1983
1982
1983
1984
1982
1983
1981
1983
1987
1988
1989
1982
1982
1983
1998
1998
1998
1999
1998
1998
1999
2001
2002
2002
2002
2002
1982
1983
1983
1989
1990
1995
1998
1980
1981
1981
1981
1982
1982
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
Change in
Change in
total gross gross external
public debt
public debt
as a share
as a share
of GDP
of GDP
(Per cent)
-7.1
-11.7
-6.1
-10.9
-1.3
-2.9
-5.9
1.2
-6.3
-5.6
-12.5
-9.8
-8.8
-14.2
-10.9
-5.9
-6.7
417.7
161.7
95.7
378.5
71.1
60.5
78.7
83.1
95.2
12.7
127.6
n.a.
111.4
146.8
43.9
191.1
95.7
53.4
106.9
117.9
302.9
35.2
16.0
35.5
32.7
62.1
39.7
73.4
34.2
87.7
68.7
8.8
32.1
46.6
1994
1995
x
x
x
x
-7.6
-4.1
-5.9
26.4
14.5
20.5
47.0
41.3
44.2
1997
1997
1997
1997
1997
x
x
x
x
x
x
x
x
x
x
-14.4
-6.4
-9.6
-2.7
-11.5
-9.6
246.0
278.8
7.1
10.4
597.7
246.0
100.9
65.3
38.1
42.5
28.0
42.5
1999
1998
1998
1998
1998
1998
1998
x
x
-5.8
-6.6
-5.1
2001
2000
2001
x
x
x
x
x
x
x
2002
2002
x
x
x
x
117.5
49.9
39.5
70.0
-15.2
144.4
208.1
-3.3
88.6
22.5
60.0
20.8
28.9
96.4
n.a.
46.1
35.1
149.9
18.5
60.7
10.1
35.1
1999
1998
x
x
-1.2
-7.1
-11.7
-2.0
-7.8
-10.5
-6.2
Note: Country and crisis listings: Countries are listed in order of earliest crisis year of the three types of crises listed, referred to as time T, and then
alphabetically; source for dates of the currency, debt and banking crises is Laeven and Valencia, 2008.
Capital flow bonanza: An “x” indicates that a capital flow bonanza occurred within any one of three years preceding the earliest crisis date; source:
Reinhart and Reinhart, 2008.
Domestic credit boom: An “x” indicates that a domestic credit boom was identified preceding time T in one of three sources: Arean et al., 2015;
Elekdog and Wu, 2011, or Takáts and Uper, 2013.
Minimum real per capita GDP growth: This refers to the lowest annual growth rate within four years of the beginning of the crisis (i.e. the range
is time T to (T+3)); source: World Bank, World Development Indicators database.
Public debt: Total gross central government debt includes both domestic and external debt. Total gross external government debt includes all
external debt owed to both the public and private sectors. Percentage changes are based on UNCTAD secretariat calculations; source: Reinhart
and Rogoff, 2010a, except for data on Ukraine, which is from de Bolle et al., 2006, and percentage changes are based on UNCTAD secretariat
calculations of the change between (T-1) and (T+2).
Financialization and Its Macroeconomic Discontents
crisis since the 1930s, commodity prices were high
and real interest rates low. Flush with petrodollars,
many developed-country banks provided financing
to (mostly private) borrowers in developing economies as an alternative to the lacklustre investment
opportunities at home. The fact that the loans were
overseen by banks (and not based on bonds) was
supposed to enhance information and oversight, adding to the general sense of confidence and optimism
that prevailed (Reinhart and Rogoff, 2009). Many
developing countries used these funds to cope with
oil price shocks, maintaining growth in the face of
mounting balance-of-payments constraints; even oil
exporters borrowed heavily, drawn in by international
lenders eager to extend loans (Palma, 2003). At the
policy level, a number of Latin American countries
introduced financial deregulation and trade liberalization in the 1970s, especially those in the Southern
cone (Argentina, Chile and Uruguay).
Beginning in 1979, there was a series of global
economic shocks involving real interest rate hikes.
These were a consequence of United States efforts
to tame inflation, intensified recession in developed
countries and a fall in non-oil commodity prices. As
a result, optimism swiftly gave way to panic. The
cut-off in lending, balance-of-payments crises and
devaluations that ensued led to a cascade of defaults
(see table 2.1 for a partial list). In response to the
alarming spectre of widespread bankruptcies, Latin
American governments nationalized what had been
largely private debt, with renegotiation and servicing
orchestrated by international financial institutions
on the condition of implementing stabilization and
structural adjustment programmes (Díaz-Alejandro,
1985; Younger, 1993; Damill et al., 2013).
Looking back at this period, there were several
reasons to be critical of domestic policy choices, such
as liberalizing domestic financial markets without
implementing adequate oversight, or underestimating
the deleterious effects of real-exchange-rate appreciation in the context of trade liberalization. But DTEs’
domestic policies and economic structures varied
much more than critics typically emphasized. For
instance, some Governments had relatively interventionist models of economic governance (e.g. as
in Brazil), while others engaged in more free market
reforms, including financial liberalization (e.g. as in
Argentina, Chile and Uruguay). A third set had open
capital accounts but imposed limits on private sector
access to external finance (e.g. as in Mexico and the
41
Bolivarian Republic of Venezuela) (Díaz-Alejandro,
1984). What these countries did share were the same
external economic conditions that generated capital
flow bonanzas in the years leading up to the crisis,
a consequent build-up of financial fragility, and the
inevitable crash that followed on the heels of common economic shocks (Stiglitz, 2003).31 Explicit
and implicit public guarantees of private debt then
transformed the crises into sovereign debt problems.
Predictably, given the dominant economic paradigm of the era, early economic models that grew out
of the experiences of the 1980s debt crises focused
primarily on the challenges of “fiscal sustainability”,
and how fiscal deficits and expansionary policies, for
instance, made economies vulnerable to speculative
attacks in the context of effectively fixed exchange
rate regimes (e.g. Krugman, 1979; Obstfeld, 1994).
Accordingly, government missteps could generate a
loss of investor confidence, inducing a self-fulfilling
prophecy as investor fears would fuel the currency
depreciation that had sparked their unease in the first
place (Krugman, 2014). The conventional wisdom
that emerged emphasized getting a country’s fiscal house in order, and letting markets do the rest
(Calvo, 2005). This perspective was also reflected
in the policy prescriptions associated with structural
adjustment, which accorded priority to servicing debt
and required liberalization and privatization.
(b) The return of capital flows to
Latin America
In 1989, Mexico signed on to the United States
Government’s Brady Plan, which was designed to
further encourage free market reforms and ease debt
burdens by converting government debt into bonds
collateralized by United States Treasury bills. A
number of other countries swept up in the 1980s debt
crisis soon followed Mexico’s example. This marks
the beginning, particularly in Latin America, of the
era where the Washington Consensus on economic
policy dominated much of the thinking on how to
manage global integration and the domestic economy,
including strong commitments to financial liberalization and privatization (Damill et al., 2013). These
reforms and debt restructurings eased concern over
fiscal debt, alleged as to be the key policy mistake
of the 1980s, and reopened access to international
capital for debtor countries.
42
Trade and Development Report, 2015
Attracted by relatively high rates of return,
and reassured by domestic policy reforms and the
prospect of a satisfactory conclusion of the negotiations on the North American Free Trade Agreement
(NAFTA), portfolio investors herded into Mexico,
driving booms in domestic credit (helped by the
privatization of commercial banks) and stock prices,
but this did little to boost real GDP growth (Grabel,
1996). In 1994, an increase in interest rates in the
United States, as well as a series of destabilizing
political events, ended the capital flow bonanza and
necessitated the drawing down of reserves in order
to finance the substantial current account deficit
(Moreno-Brid and Ros, 2004). International investors became concerned that Mexico’s exchange
rate, which was essentially pegged to the United
States dollar, was headed for devaluation. As these
self-fulfilling crises typically work, the consequent
capital outflows induced the currency crisis that
investors had feared. In the lead-up to the crisis,
Mexico’s increasing reliance on dollar-denominated
debt instruments called tesobonos introduced additional risks, stoking investors’ fear of default and
crisis (Lustig, 1995). The Clinton Administration
helped secure a quick bailout that gave priority to
bond repayment and furthered neoliberal reforms
(FitzGerald, 1996; Grabel, 1996).
The Mexican crisis created devaluation pressure
among a number of other emerging markets as worried investors re-evaluated risk in the context of fixed
exchange rates (the so-called “tequila effect”). The
strongest impact was felt in Argentina. In early 1991,
Argentina had established a currency board, which
maintained a fixed peg of its currency to the United
States dollar and established that the monetary base
would be entirely covered by international reserves
(an arrangement that persisted to 2001, when the
crisis that the scheme helped to build finally erupted).
While the regime was effective at curbing high inflation, the liberalization of trade and finance led to an
appreciation of the real exchange rate, increasing
current account deficits and external debt (Damill et
al., 2013). When the Mexican crisis struck, Argentina
also faced sudden capital outflows, mainly from
residents’ deposits in domestic banks. The pressure
on Argentina’s banks proved too strong, forcing the
government to negotiate a bailout agreement with the
IMF in 1995. IMF support, which was conditional
on the Government tightening its fiscal policy by
increasing taxes, opened the way for significant foreign financing of government debt (Calcagno, 1997;
Boughton, 2012). Brazil avoided a similar fate largely
by raising short-term interest rates, which introduced
other fragilities (i.e. persistently high interest rates,
including on public debt) that rendered it susceptible
to crisis later in the decade (Palma, 2011).
Though limited in scope and relatively shortlived, these crises challenged some of the conventional
wisdom on the determining roles of fundamentals
and liberalization, as well as the reputation of some
of the “star students” that had followed this policy
advice (Boughton, 2012: 487–488). There were
some efforts to suggest the lack of domestic savings
as an insufficiently recognized vulnerability, but the
spectacular savers caught up in the Asian financial
crisis a couple of years later quickly undermined
that line of reasoning (Calvo, 2005). A more enduring alternative explanation, for what would become
a common neoliberal “exceptionalism” story, laid
the blame for the crisis squarely on the Mexican
Government for economic mismanagement, political
overreach and corruption (Grabel, 2006). Echoes of
this reasoning would reappear to try and explain the
Asian financial crisis.
(c) The Asian financial crisis and beyond
If the Mexican crisis caught many by surprise,
the Asian financial crisis came as a veritable shock.
Most of the region’s macroeconomic fundamentals
seemed indisputably sound: growth and savings
rates were high, and since fiscal policy was generally conservative, most borrowing was private. In
1996, the year before the crisis hit, current account
deficits in Malaysia and Thailand were on the large
side,32 and the region’s overall growth had declined
slightly, but none of this really justified the extreme
alarm and consequent dislocation that would soon
follow (Krugman, 1999).
As with other crises, the pathway to the Asian
financial crisis began with financial liberalization,
both on the capital account and in domestic financial
markets (Montes, 1998). These reforms were partly in
response to pressure from domestic firms and banks,
which were eager to access lower interest loans in
global capital markets for investments at home; and
large institutional investors in developed countries
were happy to oblige (Wade, 1998). South-East
Asian governments caved in to the pressure, and,
in some cases, had developed vested interests in
Financialization and Its Macroeconomic Discontents
allowing property bubbles to grow (Wade, 2004).33
The practical result was widespread expansion of
private lending, much of which was linked to shortterm, hard-currency-denominated debt instruments
(Grabel, 1999). At the same time, capital inflows
were associated with higher rates of inflation and
real exchange rate appreciation, leading to a loss of
international competitiveness and worsening current accounts (Chandrasekhar and Ghosh, 2013).
These changes drove even more investors into the
real estate and stock market bubbles, especially in
South-East Asia. With growing signs of weakness
in Thailand’s asset markets by 1995, and global
capital starting to shift away from emerging markets
as the United States Federal Reserve raised interest
rates in March 1997, investors became increasingly
worried that Thailand’s pegged exchange rate would
not hold (Wade, 1998). The Thai central bank, after
unsuccessfully using its reserves to defend the baht
against speculative attacks, finally let the currency
float in July 1997. The baht’s consequent depreciation
spooked investors, setting off contagion first to neighbouring economies in South-East Asia (Indonesia,
Malaysia and the Philippines), and then to Hong
Kong (China), the Republic of Korea and Taiwan
Province of China.34 The IMF swiftly moved in to
help contain the crisis, pushing an agenda that has
since been criticized for possibly worsening the contagion and deepening the crisis (Radelet and Sachs,
2000), as well as over-reaching in its imposition of
market-oriented structural reforms (Crotty and Lee,
2004; Stiglitz 2002).
Outside Asia, the Russian Federation was next
to be pulled into a crisis. Soon after liberalizing
finance and allowing more foreign participation
in its stock and public bond markets, the Russian
Federation faced an increasingly widespread reversal
of capital flows to emerging markets – initially led in
the Russian Federation’s case by the exit of investors
from Brazil and the Republic of Korea in response to
the Asian financial crisis (Pinto and Ulatov, 2010).
Declining commodity prices further compromised
the ability of the Russian Federation to defend its
fixed exchange rate, resulting in devaluation and
default in 1998. The large private sector losses (both
domestically and among international investors) generated by the Russian crisis induced a sudden stop of
capital flows to Latin America, which manifested as
a series of financial crises and low growth that came
to be dubbed the “lost half-decade” of 1998–2002
(TDR 1999; Calvo and Talvi, 2005).
43
The experiences of Argentina and Brazil illustrate these dynamics and their links with vulnerabilities established in prior crises. Brazil’s system
of public financing was severely weakened by its
efforts to weather the tequila crisis, where in addition
to raising interest rates, a banking sector restructuring loaded the Government with lots of additional
debt. The economic slowdown and very high interest payments caused Brazil’s internal fiscal debt to
soar between 1994 and 1998, with interest on public
domestic debt amounting to 3.4 per cent of GDP in
1994 and 7.3 per cent of GDP in 1998 (TDR 1999;
Sainz and Calcagno, 1999).35 Defending the currency
peg in light of the sudden stop in capital inflows and
insufficient reserves became quickly untenable, and
currency crisis and devaluation ensued in early 1999.
In Argentina, with unsustainable exchange rates,
any economic growth increased its trade deficit, but
the lack of growth led to a fiscal deficit: neither of
these deficits was consistent with the convertibility
regime. This contradiction could be circumvented as
long as external financing kept flowing. However,
when that stopped, tough fiscal austerity and IMF
assistance could not prevent an economic implosion,
a run on deposits and a partial default on public debt
(Calcagno, 2003; Calvo and Talvi, 2005; Damill et al.
2013; Grabel, 2006). Real average annual per capita
GDP growth in Argentina sank to -4.2 per cent during the lost half-decade, while the average for Latin
America as a whole was 0.2 per cent.36
(d) Public sector finances in the context of
financial liberalization and systemic risk
This brief review clearly suggests that the likelihood of financial crises increased as DTEs liberalized
their capital accounts and domestic financial markets,
which led initially to surges in capital inflows and
then to the sudden stops or reversals that almost
always ensue.37 And although capital flow bonanzas
increased in tandem with free market policy stances
in developing countries, they continued to be significantly driven by circumstances external to the
economies that hosted them, such as changes in global commodity prices or in United States interest rates,
or by the psychological and economic contagion
effects of crises elsewhere. These external forces
interact with domestic macro policy and structure in
ways that raise overall fragility and risk. But domestic
factors are only significant when they exist within
a larger global financial system characterized by
44
Trade and Development Report, 2015
Table 2.2
Financial crisis and public debt in Mexico, the Russian Federation and Argentina
(Per cent)
Total gross public debt
as a share of GDP
Country (crisis date)
Mexico (1994)
Russian Federation (1998)
Argentina (2001)
Total gross external public debt
as a share of GDP
Reference
level
Pre-crisis
growth
Post-crisis
growth
Reference
level
Pre-crisis
growth
Post-crisis
growth
42.6
30.2
37.6
-29.2
34.1
19.8
26.4
39.5
208.1
37.3
31.0
47.9
-10.7
4.0
6.2
47.0
96.4
149.9
Source: UNCTAD secretariat calculations, based on data from Reinhart and Rogoff, 2010a.
Note:Time T refers to the crisis year in parentheses. The columns refer to the following:
Reference level is debt as a share of GDP at (T-3);
Pre-crisis growth refers to the percentage change between (T-3) and (T-1);
Post-crisis growth refers to the percentage change between (T-1) and (T+3).
too much liquidity and not enough macroprudential
regulation, riding on waves of optimism, excessive
private risk-taking and over-borrowing that precede
the inevitable crash – a dynamic that is endemic to
the financial system itself (Minsky, 1992).
The largely private risk-taking associated with
financial liberalization then becomes a public debt
problem. The most proximate reasons involve the
explicit and implicit guarantees that governments
provide on private liabilities and the nationalization of bad private debts. But a financial crisis also
systematically reduces public revenues and wealth
through the effects of exchange-rate depreciation on
public assets and liabilities, increases in real interest
rates, declines in real output, and the additional borrowing required to deal with the costs of the crisis
(de Bolle et al., 2006). Although sovereign defaults
are a common feature of financial crises in DTEs,
contrary to the common rhetoric around development
macroeconomics, in the cases analysed, large public
debt is most often a consequence, not a cause.
Even among countries such as Argentina,
Mexico and the Russian Federation, where public
debt was identified as a major source of the financial fragility that pushed their economies into crisis
in the 1990s, there is ample room for qualification.
Table 2.2 takes a closer look at public debt for these
three countries in their respective pre- and post-crisis
years. Reference level refers to public debt as a share
of GDP three years prior to the crisis date (T-3), and
pre-crisis growth to the percentage increase in that
level over the three years leading up to the crisis. By
way of comparison, the growth in public debt after
the crisis presented in table 2.1 is repeated here.
Total and external public debt as a share of GDP
for Mexico was actually on the decline before the
crisis, while the pre-crisis debt levels of the Russian
Federation and Argentina certainly did not portend
the crises that followed. However, these figures do
not capture how the structure of debt makes DTE governments more vulnerable than their debt levels
suggest (e.g. the extent of foreign-exchange-linked
liabilities and short-term maturities). Even then, there
are arguments to be made about the respective roles
of fiscal profligacy versus having to bend to the rules
of global financial markets.
3. Looming losses: Fiscal stance,
macro policy and aggregate demand
This chapter shows that exposure to unregulated and large financial flows alters macroeconomic
developments in ways that can lead to a slowdown
of GDP growth as well as unstable internal dynamics marked by sudden shifts of income and wealth
between the main sectors (private, public and
external). A convenient way to map these shifts and
their relationship with economic growth is by using
the “demand stances” framework (see Godley and
Cripps, 1983; Godley and McCarthy, 1998; and
Financialization and Its Macroeconomic Discontents
Taylor, 2001 and 2006). This framework reasserts the
Keynesian principle that sustained growth requires
continuously increasing injections (which, in simple
macroeconomic terms, include private investment,
government expenditure and exports) into the flow
of income. These injections, in turn, require a steady
growth of leakages (measured by the propensity to
save, the tax rate and the import propensity), which
over time ensure financial stability, as credit rises
along the circular flow of income. Thus GDP growth
can be explained as the growth, along stable norms,
of injections relative to leakages; these eventually
determine financial transfers between the main sectors. Such ratios of injections to leakages are termed
stances and provide a measure both of demand drivers
and financial balances.38
Therefore, a useful way to assess changes in
behaviour is to trace the patterns of the three stances
(fiscal, private and external) along the path of growth.
Each of the three stances can be observed relative to
GDP in order to see which components of aggregate
demand are contractionary and which provide stimulus to the economy. Weaker fiscal stances (declines
in government expenditure relative to the tax rate),
weaker private stances (declines in investment relative to the savings propensity), and weaker external
stances (declines in exports relative to the import
propensity) adversely affect the growth path and may
generate financial imbalances that increase financial
instability.
Applying this framework to the crises discussed
in the previous section and listed in table 2.1, we find
that in two thirds of these cases, the leading source of
demand shifted away from the domestic stances (private and government) before the crisis, and towards
the external stance after the crisis.39 This reflects a
tendency, post-crisis, for external accounts to go into
surplus while domestic sources of demand taper off.
Structural trends and cyclical effects jointly come into
play. Current account liberalization prior to a crisis,
along with financial inflows and strong exchange
rates, allow an expansion of domestic demand with
substantial import leakages. After a crisis, wage
compression and lower profits, along with fiscal
contraction and interest rate hikes to attract capital
inflows, weaken private sector stances and lower
imports. Stronger external stances mostly derive from
a decline in domestic demand and the consequent
swift reduction of imports. Regarding the domestic
sectors, the triggers are a shift towards deleveraging
45
of households (higher saving propensities) and a
contraction of government expenditure when austerity is applied (particularly after private sector losses
are transferred to the public sector and fiscal imbalances grow as a result). Further, depreciation of the
exchange rate can frequently make the foreign sector
the leading source of effective demand without any
substantial increase in real export capacity.
Two additional considerations serve to highlight
the usefulness of the framework described above to
trace demand drivers in some DTEs after the crisis:
(i) the buffer role played by commodity export revenues, and (ii) changing views on countercyclical
fiscal policy among DTEs. Rising commodity prices
(a trend now in reversal) have sustained – at times
narrowly – private sector profitability, preserving
optimism in the face of ongoing financial volatility. In
addition, when growth across the South decelerated in
2009 due to a contraction of exports to the North and
the sudden stop of capital inflows, countercyclical
policy responses made a recovery possible in 2010
(Grabel and Gallagher, 2015). Despite these ephemeral reversals on countercyclical policy conventions,
powerful financial market institutions maintain their
biased, short-term perspective which hangs on the
importance of financial ratings (see also chapter IV).
A policy aversion to providing a strong fiscal stimulus
has been the rule. Fiscal orthodoxy and an excessive
reliance on monetary policy have generated financial
fragility and exchange-rate instability in major developing economies (Akyüz, 2013). Susceptibility to
financial pressures is heightened either when public
sectors incur debt directly or, as is more frequently
the case, circuitously when increased liquidity generates private sector debt that is ultimately taken on by
the public sector. Interest payments on debt, whether
public or private, further dampen domestic stances.
To summarize, the most important elements
that were present in previous crises and which
persist today are: open capital accounts; hot money
cycles worsened by monetary expansion in developed countries and a consequent rise in external
and internal debt (in particular short-term debt); a
shift away from deepening industrial development;
and constraints on using fiscal policy as a tool for
structural transformation and industrial expansion,
as monetary policy continues to promote the deflationary trends favoured by global financial investors.
Very broadly, these features apply to many countries
today to varying degrees, depending on their financial
46
Trade and Development Report, 2015
flows, stocks of debt, and movements in exchange
rates and interest rates. Clearly, the most vulnerable
economies are those where domestic activities are
highly concentrated in only a few sectors.
D. Concluding policy discussion
The analysis in this chapter has focused on
the reshaping of global financial markets, leading
to the Great Recession and its aftermath to the pre­
sent day. The extraordinary growth of unregulated
global financial markets, in tandem with weaker
domestic regulation in most DTEs, has exacerbated
the vulnerabilities of these countries, rather than
providing increased financing for development
needs (discussed in chapter VI of this Report).
The chapter has stressed that excessive private
capital inflows, particularly those of an unstable
or speculative nature, affect the configuration of
net factor payments, exchange rates, interest rates
and other prices, and influence monetary and fiscal
policy stances in perverse ways. When DTEs face
the threat of sudden stops or capital flow reversals
as conditions in global markets change, the results
can be even worse. It is clear from the discussion
that under these circumstances, policymakers’ search
for alternatives to ensure more stable outcomes is
becoming increasingly challenging.
2007; Damill et al., 2013). The management of the
exchange rate (as described by these authors and
others) with a view to guiding its evolution as a tool
for development entails combinations of monetary
policy, central bank operations and incomes policies. How this is achieved in practice depends on the
particular circumstances in each country, including
their institutional diversity and their balance sheets.40
A significantly more stable macroeconomic
environment for development is implausible without
collective efforts to reform the international monetary
and financial architecture, the subject of chapter III.
Nevertheless, there are a number of options that still
remain within the purview of national policy. To be
clear, none of the proposed recommendations call for
delinking from the global economy in terms of either
trade or finance, but rather for better managing the
links to promote development.
As discussed above, guiding the evolution of
the real exchange rate in an environment of large and
deregulated global finance, and a global exchange
system dominated by a few reserve currencies,
will be extremely difficult without some degree of
management of the capital account. The possible
use of capital controls as a tool for development and
financial stability has gained greater acceptability by
many governments and international organizations
in recent years. Indeed, UNCTAD has been a longstanding advocate of such a policy: in the early 1990s,
it suggested that DTEs should consider measures that
“discourage capital flows that were not related to real
investment or to trade transactions but were motivated by short-term gains” (UNCTAD, 2012b: 50).
These and complementary recommendations aimed
at restoring stability and averting systemic crises
are even more relevant in today’s context, as also
evidenced by developed countries severely hit by the
Great Recession and its aftermath. Again, the circumstances and scope for action differ from country to
country, as does the degree of regional coordination
required to ensure success.
One set of critical policy choices rests on the
ability to influence the exchange rate. While avoiding “corner solutions”, such as fixed exchange rates
or fully liberalized exchange rates, some sort of
managed float remains an attractive option (Ghosh,
In an effort to avoid the currency and interest
rate risks historically associated with external debt,
DTEs have also shifted more of their borrowing
from debt denominated in foreign currencies to one
denominated in domestic currency. 41 But not all
Financialization and Its Macroeconomic Discontents
developing countries can attract international investors to domestic securities markets. And even when
they do, there is the additional risk that larger shares
of debt, regardless of currency denomination, will
be held by more internationally mobile investors.
Recent evidence bears out this warning: greater
foreign participation in domestic currency sovereign
bond markets has been associated with heightened
volatility as a result of increased exposure to global
financial shocks (Ebeke and Kyobe, 2015).
A similarly mixed result is seen in the growth
of international reserves among DTEs. The build-up
of reserves is in principle mostly precautionary, in
the sense that it is expected to guard against a host of
ills introduced by large and speculative international
capital inflows and the negative economic and social
consequences of their sometimes sudden or substantial departure. Precautionary reserve buffers also
hedge against the loss of policy autonomy that often
accompanies IMF-type bailouts or against pressures
to provide the macro policy conditions preferred by
international financial investors (Grabel, 2006). But
even if reserve accumulation does offer some protection, providing some policy space to countries whose
currencies are under attack, there is an opportunity
cost to tying up development resources in this manner. Furthermore, when policymakers try to counter
capital flow reversals through the use of reserves, they
often end up resorting to complementary measures,
such as interest rate increases, as the stock of reserves
declines. These policy responses ultimately weaken
the economy and erode confidence even further. As
noted above, such trade-offs pose a challenge to
central bank policy.
In considering policy options, central banks
in DTEs should carefully evaluate the implications
of narrowly applied inflation-targeting regimes.
Pressing too hard to achieve inflation rates deemed
desirable more often in developed-country contexts
could easily lead to high interest rates and appreciation of the real exchange rate, both of which
discourage productive investment and hence development. Still, the widespread (formal and informal)
adoption of inflation targeting by some developing
countries’ central banks reflects real apprehension
over any hint of inflation, given their histories of
high inflation. But probably more important is the
widespread belief that inflation targeting regimes give
more credibility to the central banks that implement
them, lowering expectations of inflation and enabling
47
higher employment rates for a given level of inflation.
However, the empirical evidence does not support the
credibility argument (Epstein, 2007). Indeed, stable
price formation processes and sustained increases of
high-quality employment in a developing country
context are complex goals that require attention to
the overall stability of credit and financial flows.
But central banks can do more than only maintain price stability or competitive exchange rates to
support development, as attested by the historical
record. After the Second World War, central banks
in Europe and Japan used interest rate ceilings, subsidized credits and credit allocation policies to guide
reconstruction and facilitate industrial upgrading
(Epstein, 2015). Similar policies were followed by the
newly industrializing countries in the second half of
the twentieth century, where central banks provided
key support to development banks and their governments’ fiscal policies (Amsden, 2001; TDR 2013).
Price stability goals can still help guide these types
of policy choices, as when targeted or subsidized
credit encourages productivity and employment
growth rather than activities that generate inflationary pressures (Epstein and Yeldan, 2009), or when
incomes policies ensure that wage growth tracks
productivity growth.
However, as evidenced by the failures of developed economies to fully emerge from the recent crisis,
monetary policy alone is not sufficient. Proactive fiscal and industrial policies are essential for generating
the structures and conditions that support domestic
productivity growth and the expansion of aggregate
demand. Maintaining strong and stable fiscal stances
can help increase production and incomes, generate
high-quality employment, and encourage a more
egalitarian distribution of income (which exerts a
further positive effect on aggregate demand). Policies
that ensure that wage incomes increase concomitantly
with productivity growth enhance these mechanisms.
By extension, trade policy also needs to be aligned
with domestic goals and policies for productivity
and wage growth, including in global, regional and
bilateral trade negotiations (see TDR 2014).
These circumstances highlight the need for more
effective international policy coordination. Given
the sheer size of global capital flows, individual
countries’ management measures, such as capital
controls, exchange rate management, central bank
policy consistent with strategic development needs,
48
Trade and Development Report, 2015
and a tighter regulation of domestic financial systems,
may not be enough. Domestic policy options should
be supplemented by global and regional measures that
discourage the proliferation of speculative financial
flows. In addition, more substantial mechanisms
could be established for credit support and shared
reserve funds at the regional level. At the same
time, implementing countercyclical macroeconomic
policies, improving income distribution and extending fiscal space for development purposes have a
significantly greater chance of success when applied
also by partner countries, and effectively, the world at
large. Indeed, domestic policy stimuli, when applied
by only a few countries, are considerably weakened
when the inertia of macro policy orthodoxies prevails
in partner countries.42 Such conditions can even yield
perverse effects if global investors and international
financial institutions respond in ways that generate
greater volatility and uncertainty. These aspects are
discussed further in the next chapter.
Notes
1
2
3
4
Although middle-income countries tend to be more
integrated into the global economy, and as such,
seemingly more exposed to the effects of financialization, the magnitudes of capital flows relative to
GDP and their macroeconomic effects discussed in
this chapter apply to all DTEs (see section B.2 for
more detail.)
Among a group of 26 developed countries, all but 4
(France, Japan, Sweden and Switzerland) had contractionary fiscal stances relative to their long-run
trend between the second quarter of 2010 and the
fourth quarter of 2013 (TDR 2014, chart 2.1).
See Chandrasekhar (2007) for an analysis of factors
that led to an explosion of global liquidity creation
by private agents after the 1997 Asian crisis, which
was transmitted to developing countries through the
operations of hedge-funds, foreign direct investment
in the form of portfolio equity and increased mergers
and acquisitions.
Think tanks providing analytical insights for inter­
national investors trumpeted the potentially attractive returns of developing economies. See, for
example, Accenture, 2012; Black Rock, 2011; Credit
Suisse, 2011; Economist Intelligence Unit, 2011;
UBS, 2012; and Ahmed and Zlate, 2013, for a more
rigorous analysis of factors determining the relative attractiveness of emerging market economies
as investment destinations. (The latter study also
evaluates the influence of the unconventional monetary policy of the United States as a factor in the
composition of flows, a large proportion of which
are portfolio allocations.)
5
6
7
8
9
10
The crash in China’s stock market in June–July
2015, and the Government’s responses to it, echo
these worries (Bloomberg Business, “China stocks
plunge as State support fails to revive confidence”,
8 July 2015).
The World Bank’s International Debt Statistics 2015
contains records of 125 countries, of which 121 are
DTEs according to the United Nations classification.
Unless otherwise specified, the empirical discussion
refers to this group of 121 DTEs. Elsewhere in the
chapter the term DTEs refers to all developing and
transition economies.
These are identified as all the 121 DTEs minus
Algeria, Argentina, Brazil, China, Egypt, India,
Mexico, Morocco, South Africa, Tunisia and Turkey.
There are a few exceptions among DTEs where current account deficits in the 2000s were significantly
larger than those in the 1990s, including, most notably, India, South Africa and Turkey.
Even countries with a current account surplus
obtained additional financing to manage their portfolios, increase their asset accumulation buffers in
view of uncertainties, and cope with intertemporal
inconsistencies (since expected expenditures are
decided in advance of earned income), or even for
financial speculation purposes.
The current account is the sum of the trade balance
and the balance on transfers and net factor incomes.
Net factor incomes are primarily the earnings on
outward investments and loans less payments made
to foreign investors and creditors. Remittance flows
from residents working abroad are also accounted
Financialization and Its Macroeconomic Discontents
11
1 2
1 3
1 4
15
16
1 7
1 8
1 9
20
2 1
22
23
as factor incomes and for some DTEs (e.g. India,
Mexico and the Philippines) the size of such flows
is substantial.
Any statistical errors between the current and the
capital and financial accounts in the balance of payments are captured by the “net errors and omissions”
category; this item is used to preserve the accounting
principle of equality between the current account and
the capital and financial accounts.
The discussion that follows draws from the analytical
framework developed by Kregel, 2014a.
In theory, the situation for surplus countries exposed
to unfettered capital flows would present similar
challenges. Even they could face declining trends in
net factor incomes, and therefore downward pressure
on their current accounts. Aside from other factors
driving their export successes, the prospects of falling net factor incomes might generate pressure to
compensate by aiming at ever greater trade surpluses.
While the aggregate perspective taken in this section is critical for pinpointing the macrofinancial
implications of capital flows in the current context,
the detailed analysis below sheds a different light by
distinguishing between more unstable and speculative short-term flows and those that are longer term
and more likely to be better linked to development
needs.
This configuration of policies is found, for instance,
in the United States, the eurozone and the United
Kingdom, and only partially in Japan where quantitative easing was accompanied by some degree
of fiscal relaxation. See TDR 2014 for an extensive
analysis.
This perspective is in line with recent studies such
as those by Gallagher (2015), Kaltenbrunner and
Karacimen (forthcoming), Kaltenbrunner and
Panceira (2014) and Powell (2013).
Some countries of similar relevance, such as the
Russian Federation, are not included due to the lack
of detailed data in the World Bank’s International
Debt Statistics.
The spike in private capital inflows recorded in 2005
is in fact the way the World Bank recorded debt
relief.
For a discussion about channeling FDI for the good
of development, see the joint UNCTAD/ILO volume
on industrial policy (Salazar-Xirinachs et al., 2014).
See Financial Times, “Real estate and China dominate FDI flows”, 4 June 2015.
UNCTAD, 2015: 18, table I.5.
Between 2011 and 2013, net FDI inflows to DTEs
consisted of, on average, reinvested earnings (45 per
cent) and intra-firm loans (22 per cent); the remaining 33 per cent consisted of equity, including mergers and acquisitions (UNCTAD, World Investment
Report database).
For a recent review, see Thirlwall, 2011.
24
25
26
27
28
29
30
31
32
49
See Patnaik (2007) for an analytical exposé of the
limited effectiveness of precautionary holdings of
foreign-exchange reserves; and also Torija Zane
(2015), with special reference to central banks in
Latin America.
For formal derivations of the points made here, see
Patnaik and Rawal, 2005; and Patnaik, 2006.
Herndon et al. (2013) replicate and empirically
challenge Reinhart and Rogoff (2010b and 2010c),
whose writings have been widely used to support
fiscal austerity arguments based on the stylized finding that public debt exceeding 90 per cent of GDP
reduces growth. Herndon et al. (2013) conclude that
Reinhart’s and Rogoff’s selective exclusion of data,
coding errors and inappropriate weighting of summary statistics underlie the result on public debt and
growth. When these errors are corrected, the results
show that the growth consequences of public debt
vary and the effects are modest.
In Latin America, the context of overvalued ex­change
rates, expanding domestic demand and a more open
trade regime, “led to increased imports and a growing current-account deficit, which was financed by
foreign investors who were attracted by the promise
of higher returns. However, the creative process of
technological progress and restructuring remained
to be carried out, and the macroeconomic environment of high interest rates, strong exchange rates
and volatile capital flows did little to support the
new investment required for such a transformation.
Thus policy reforms were unsuccessful because the
‘creative’ element in the ‘destruction’ process failed
to bring about real transformation of the productive
structure through higher investment and technological change” (TDR 2003: 145–146).
These ripple effects are grouped separately from
the Asian financial crisis in order to differentiate
between the regional contagion of that crisis and
how these costs manifested in other emerging market
economies.
These data and the term “capital flow bonanza” are
from Reinhart and Reinhart (2008), who note that,
although a better measure would be reserve accumulation less the current account balance, the longer
time series and greater consistency of data on the
current account make this a satisfactory substitute.
This section limits the discussion to Latin America.
Many other developing countries were swept up
in the same cycle of financial crises, but the Latin
American experience is emblematic of the larger
economic forces at work.
Even Brazil, which had capital controls and did not
experience much capital flight, suffered because of
the general suspension of lending to Latin America
(Díaz-Alejandro, 1984).
As a share of GDP, the current account deficits
of Thailand and Malaysia that year were -8.1 and
50
3 3
34
35
36
37
38
Trade and Development Report, 2015
-4.4 per cent respectively (IMF, World Economic
Outlook database, October 2014).
Wade considers the Republic of Korea a different case on the grounds that there it was more the
industrial conglomerates that had links with finance
through their access to cheap foreign capital, rather
than vested interests in property.
Taiwan Province of China and Hong Kong (China)
successfully fended off speculative attacks, but the
Republic of Korea was much more exposed because
of short-term debt.
By contrast, government spending on goods and
services as a share of GDP rose from 19.2 per cent
in 1994 to 20.6 per cent in 1998, with the bulk of the
rise occurring in 1995 (when it increased to 21 per
cent) as a result of a one-time positive shock of
inflation-related adjustment of wages and salaries
(UNCTADstat).
Source: World Bank, World Development Indicators
database.
See also Demirgüç-Kunt and Detragiache,1998;
Reinhart and Reinhart, 2008; and Weller, 2001.
In mathematical terms, the main accounting identity
defines GDP as the sum of consumption (C), private
investment (I), government expenditure (G) and
exports (X) minus imports (M). Simple assumptions
allow specifying the tax rate (t) and the savings and
import propensities, s and m respectively, as:
T = t · GDP; S = s · GDP; M = m · GDP,
where T stands for total tax revenue and S for private
savings. Arrangements of these equations around the
accounting identity yield the expression:
GDP = (G + I + X)/(t + s + m), or alternatively:
GDP = wt · (G/t) + ws · (I/s) + wm · (X/m)
where wt, ws and wm are the weights of each of
39
40
41
42
the leakages (tax, savings and import propensities, respectively). This equation establishes that
growth of GDP depends on the growth of the three
variables, G/t, I/s and X/m; defined as fiscal stance,
private stance and external sector stance, respectively, amplified by the strength of the respective
multipliers, given the mentioned weights, in the
macroeconomic context. To avoid complicating
the presentation with derivation of the steady state
conditions, it is sufficient to note that these stances
reflect financial conditions as well, where a larger
numerator than the denominator points towards a net
borrowing position. Thus, a steady path of sustained
growth and financial stability requires that none of
these stances grow at a proportionally faster pace
than the others for a prolonged period of time.
The external account became the leading driver in
40 per cent of these cases, and became significantly
more important in another 27 per cent of cases.
See Frenkel and Taylor (2006) for a discussion of
the varying circumstances and challenges that are
associated with managing the exhange rate to support
development.
Data from the World Bank (2013) indicate that at
the end of 2012 the share of non-resident holdings
in local DTE debt markets was 26.6 per cent, and
that it was as high as 40 per cent in some economies
(cited in Akyüz, 2014: 20).
See TDR 2013, annex to chap. I, where a global
model simulation provides empirical illustration
of the fact that policies based on improved labour
income and supportive fiscal policy yield weaker
results, even if still positive, when partner countries
take an opposite stance and profit in a typical “freerider” manner.
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